LONDON, June 20 Investors are seeking new
defences against possible falls in European stocks as indexes
plateau near multi-year highs and traditional hedges prove
ineffective in a market anaesthetised by near-zero interest
rates.

These alternative tools range from option strategies aimed
at minimising the cost of holding a hedge to investing in funds
which aim to generate some returns irrespective of the stock
market's direction, such as arbitrage hedge funds.

A 50 percent rally in European shares over the past two
years has left investors fretting about high valuations and
seeking to protect their gains against a possible selloff.

However, hedging tactics which worked during the jittery
days of 2008 and 2011, such as straight bets on rising
volatility, have proved inadequate in the current, becalmed
market conditions, leading fund managers to look for
alternatives.

"A direct exposure to volatility may hurt investors because
volatility can still fall or stay at a low level for a long
period of time," said Bruno Pannetier, chief investment officer
of London-based hedge fund Old Park Capital. "Investors have to
find new ways of hedging."

Hedging equity positions via futures on the Euro STOXX
Volatility index <0#FVS:> (VSTOXX), which gauges the
prices of options on euro zone blue-chips and tends to move
inversely to cash equities, has cost investors dearly over the
past two years.

Firstly, the VSTOXX has fallen roughly 65 percent since the
Federal Reserve and the European Central Bank made plain in 2012
that they were prepared to pursue radical measures. The index
has shown no sign of revival because the magnitude of swings in
the Euro STOXX 50 index has been even lower than option prices
imply.

Furthermore, since futures with longer-dated maturities tend
be more expensive than shorter-dated ones at times of low
volatility, investors would often have to stump up when selling
an expiring contract to buy a new one.

To reduce this cost, some investors are buying a cheaper
volatility future and selling a more expensive one, betting the
latter will lose value as time passes.

"We have observed a trend for people to look for solutions
that provide exposure to long volatility but minimise or reduce
the cost of carrying that position," said Ryan Rogowski, head of
asset manager solutions at Societe Generale.

"Of course there's no free lunch so ... investors must take
a view."

EXPENSIVE OPTIONS

Similar strategies can be implemented via put options, bets
the market will fall.

Some investors are taking out "put spreads", or financing a
put by selling another put with a lower strike price on the same
stock, effectively betting that any fall in the share would be
small.

More bearish investors are opting for financing their puts
by selling a call, or bet the price will rise, on the same
security, a strategy known as a "cashless collar".

"Investors are taking down their risk positions and a
cashless collar or a put spread are a way to do this without
paying too much premium out of the portfolio," said Lorne
Baring, managing director of wealth management firm B Capital.

Demand for cross-asset protection has also been on the rise,
with investors fearing any hint at a tightening of monetary
policy would puncture the recent, twin rally in bond and stocks.

An example of these hedges, designed to protect investors
against a rise in interest rates, is an option giving the holder
the right to swap a fixed rate for one that tracks market
prices.

While buying options, however cheaply, erodes returns if
stocks rise and volatility remains low, investing in strategies
which are altogether uncorrelated with the market's direction
can boost a portfolio's performance.

Such strategies include buying equity funds in which long
and short positions cancel each other out, leaving the fund
"market-neutral", and arbitrage strategies, which seek to
exploit unusual price moves, often using algorithms.

These strategies can, in theory, outperform at times of high
volatility, where wild swings throw up buying opportunities.

"We're looking for protection and market-neutral strategies
tend to offer that," said Oliver Wallin, investment director at
Octopus Investments, a fund of funds. "I think they've got a
really good place in well-constructed portfolios."
(Reporting by Francesco Canepa; Editing by Ruth Pitchford)

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